1 bm410: investments portfolio construction 2: market anomalies and portfolio tilts
TRANSCRIPT
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BM410: Investments
Portfolio Construction 2:
Market Anomalies
and Portfolio Tilts
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Objectives
A. Understand different market anomalies B. Review active versus passive investingC. Understand portfolio tilts
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• What is a market anomaly?• A market anomaly refers to price behavior that
differs from the behavior predicted by the efficient market hypothesis.
• An anomaly discussed means it is known
• It is less like to do the same next time because others will be watching for it as well.
• Are there known anomalies?
A. Understand Market Anomalies
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Anomalies (continued)
Price Earnings Effect
• Portfolio’s of low P/E stocks have exhibited higher average risk-adjusted returns than higher P/E Stocks
• Investors prefer cheaper stocks to more expensive stocks even if risk levels are the same.
Small Firm Effect
• Smaller firms generally earn higher returns
• May be tied to fact that ownership of smaller firms is left to smaller investors who require a higher return to invest.
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Small Firm Effect
Source: Ibbotson Associates 2000
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Anomalies (continued)
January Effect
• Stocks tend to exhibit a higher return in January than any other month (higher for smaller stocks)
• May be tied to tax-loss selling or window dressing at year-end
Neglected Firm Effect
• Firms not followed by analysts tend to perform better than those followed
• Because costs are higher to analyze smaller firms, investors require a higher rate of return to invest in less liquid stocks
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Anomalies (continued)
Liquidity Effect
• Less liquid stocks sometimes perform better than more liquid stocks
• Investors may require a higher return premium to compensate for lower liquidity
Market to Book Ratios
• Stocks with lower price to book ratios (or higher book to market ratios) perform better
• Investors prefer to invest in cheaper stocks (in reference to their assets) than more expensive stocks
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Book to Market Ratios
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Anomalies (continued)
Reversals
• Extreme stock market performance tends to reverse itself, i.e. reversion to the mean.
• Losers rebound and winners fall Value Line Enigma
• Stocks rated highly by Value Line perform better
• Investors may actually read Value Line
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Anomalies (continued)
Post-Earnings Announcement Drift
• The effect of earnings announcements continue for many days after the announcement
• May be due to trading costs, particularly for smaller companies
• In addition, this drift shows consistency
• If a company consistently has above market expectations, the market learns it
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Anomalies (continued)
Market Anomalies are due to:
• Risk Premia
• Are we accounting for all the appropriate risk factors, such as in an multifactor framework? (there may be more factors than just market portfolio)
• Behavior - Irrational or rational
• Investors prefer to purchase large and growth stocks and neglect small and value stocks.
• Data Mining
• By chance, some criteria will appear to predict returns. Is it logical? If not, don’t bet on it!
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Anomalies (continued)
Over-fitting the S&P 500: Butter Production in Bangladesh and the United States, United States Cheese Production, and Sheep Population in Bangladesh and the United States. R2=.99
Source for all the S&P 500 data mining graphs is: David Leinweber’s “Data-Snooping Biases in Tests of Financial Asset Pricing Models.”
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Questions
Do you understand the market anomalies?
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B. Review Active versus Passive Investing
• What is Active Portfolio Management?• Trading to earn more than a “market” return for
time and risk• It is using publicly available data to actively
manage a portfolio in an effort to consistently beat the benchmark after all costs, taxes, management, and other fees (not just from luck)
What is passive management?• Not trading to earn a market return for time and
risk.• The process of buying a diversified portfolio
which represents a broad market index (or benchmark) without any attempt to outperform the market
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Active versus Passive (continued)
What does active management require?• Active management requires a competitive
advantage in at least one of three categories:
• 1. Information. You should have information not widely available and not already reflected in stock prices
• 2. Trading costs. You should have a lower cost to trade, possibly helped by being a dealer or floor trader
• 3. Analysis. You should have the ability to convert public data into private knowledge about value that is not fully reflected in current prices.
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Active versus Passive (continued)
Does it have to be one or the other?• Why not use a combined approach
• Index when that is perceived to add value• Actively manage when you can add value there
• What about in-between?• What about enhanced-indexing?
• It is often called risk-controlled active funds or hybrid active-passive strategies
• For example, you could have a bond and equity index funds, and you could dynamically market time by varying your allocations in each fund (i.e. asset allocation)
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C. Understand Index-tilt Strategies
What is an index-tilt strategy?• It is the process of using an index as a performance
benchmark and departing from the exact index weighting in order to overweight assets or sectors you expect to outperform
Are their different types of “tilts?”• There are a number of them
• Interestingly, most are bets on the persistence of so-called long run market anomalies discussed earlier
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Index-tilt Strategies (continued)
What is the key question for anomaly-tilt strategy?• Will the market anomaly continue?• Can the excess returns from the tilt cover the
additional costs in research, trading costs and fees, and taxes?
• Is the additional return sufficient to justify the increase in fees for the active strategy?
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Index-tilt Strategies (continued)
What are some variations on index-tilting?• Suppose you want excess returns from your U.S.
portfolio. You decide on an 80% passively managed portfolio with a 20% actively managed portfolio.
• This strategy would give you the stability of the index fund (i.e. risk reduction and close to benchmark returns)
• In addition, it would give the opportunity to earn higher than benchmark returns if you do well on your actively managed portion of your portfolio
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Index-tilt Strategies (continued)
• The 20% might include:• Stocks not in the index
• Purchase assets from other asset classes that have higher than the expected returns from your benchmark
• Industry tilts • Overweighting more attractive industries
that you expect to add value above the benchmark
• Size tilts • Overweight (underweight) smaller
companies if you expect their returns to be higher (lower)
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Index-tilt Strategies (continued)
• Anomaly tilts• Invest in market anomalies that you expect to
continue, i.e., low PE or high book to market stocks
• Risk tilts • Increase (decrease) the beta if you expect is
market forecast is for higher (lower) returns• Tax tilts
• Increase (decrease) investments in high dividend (taxed at 15%) stock companies versus bonds (taxed at marginal tax rates) if your forecast for market returns is higher (lower)
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Index-tilt Strategies (continued)
• What is the key to portfolio construction?• The key is to build that optimal portfolio to help
you achieve your goals the quickest
• There are distinct advantages for active, passive, and hybrid strategies
• Understand your goals
• Understand what you want to accomplish, and
• Understand the tools that can help you achieve them
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Review of Objectives
A. Do you understand different market anomalies?
B. Do you understand active versus passive investing?
C. Do you understand portfolio tilts?